Expiration trading is a mathematical game distinctly different from stock picking. If you're seeking moderate risk by reducing market exposure and are willing to work hard, focus your attention, and practice, then trading options at expiration may be for you.

This chapter is from the book

Timing

This book was written during one of the most turbulent times in stock market history—the second half of 2008. During this time frame, trillions of dollars were lost by both bulls and bears as the world’s financial markets “melted down.” Investors who have never experienced a crashing market often believe that it is easy to generate profits in this environment with short positions. Unfortunately, nothing is ever that simple. The 2008 collapse included single-day bear market rallies as large as 11%—large enough to destroy nearly any short position. The answer lies in reducing market exposure and trading only when it makes sense.

Far too many investors have taken the opposite approach by remaining in the market with a portfolio of investments whether they were winning or losing. This approach has its own familiar vocabulary built around terms such as value investing and diversification. It hasn’t worked well for most investors. At the time of this writing, U.S. equity markets had just plunged to their 1997 levels, erasing 11 years of gains. Subtracting an additional 30% for inflation and dollar devaluation paints an even darker, but more realistic picture. As a group, long-term stock investors collectively lost an enormous amount of money—trillions of dollars.

Commodity traders faced similar problems. Oil prices climbed steeply from $27 in January 2004 to $134 in July 2008 before falling back to $50 in November. Long-term bulls actually suffered two significant setbacks during this time frame because the price fluctuated from an interim high of $70 in August 2006 to a low of $45 just five months later. Figure I.1 traces the price from January 2004 through the November 2008 decline.

Figure I.1 Weekly U.S. spot price for crude oil 2004/01/02 to 2008/11/14. Price is displayed on the y-axis, key dates are noted on the chart. Source: U.S. Department of Energy, Energy Information Agency, www.eia.doe.gov.

As always, timing is everything. But the more important lesson is that blindly hanging on with a bullish or bearish view is a flawed strategy. Every investment has a window of opportunity; unless that window can be identified, leaving the money invested is somewhat like gambling. That said, the window can be relatively long—sometimes spanning months or years.

Option trading in turbulent times can also be difficult. Implied volatilities rise sharply, making simple long put or call positions unreasonably expensive, and the risks associated with naked short positions is simply too large for any conservative investor. Structured positions such as calendar spreads, ratios, vertical spreads, and the like, are difficult to trade because stocks frequently cross several strike prices in a single month—sometimes in both directions.

These pitfalls can all be avoided by entering the market at very specific times and structuring trades that capitalize on well-characterized pricing anomalies. For option traders, the days preceding expiration represent the very best opportunity. During this time frame, traditional approaches to calculating the value of an option contract fail, and prices become distorted. One of the most significant forces, implied volatility collapse, can generate price distortions as large as 30% on expiration Thursday and 100% on Friday for at-the-money options. At the same time, strike price effects resemble the gravitational pull of planets, with stocks as their satellites. Heavily traded optionable stocks tend to hover around strike prices as large institutional investors unwind complex positions ahead of expiration. Option traders who structure day trades that take advantage of these forces can generate more profit in one day than most experienced investors realize in an entire month—sometimes an entire year.

Unlike other trading strategies that are linked—sometimes in subtle ways—to a specific set of market conditions, expiration trading focuses only on the underlying mathematics. It does not rely on any financial predictions, company results, or market direction. In this context, an expiration trader manages ticker symbols and strike prices because the name or business of the underlying stock is irrelevant. But nothing worth doing is ever easy. Trading subtle price distortions in the options market is a complex affair that requires an unusual blend of pricing knowledge and day trading skill. Expiration trading is a mathematical game distinctly different from stock picking. It will most likely appeal to day traders and other investors seeking to moderate risk by reducing market exposure. That said, this book should never be placed in the “get rich quick” section of the bookstore because success requires hard work, focused attention, and practice.